From 'MF Lite' regulations for passive funds to review of TER — Here's a look at Sebi's proposals for mutual fund industry

The Securities and Exchange Board of India (Sebi) on Monday proposed key measures for the mutual fund (MF) industry. The capital market regulator, in its annual report for 2022-23, said the measures could be introduced in the forthcoming years to adapt to the dynamic changes in the mutual fund asset management ecosystem.

The proposed measures include the introduction of MF Lite regulations for passive funds, review of total expense ratio (TER), credit default swaps (CDS) selling by mutual funds, and institutional mechanisms for deterrence of possible market abuse and fraudulent transactions, among others.

Here's a look at key proposals for the mutual fund industry:

Since the current MF regulatory framework was built around active fund management, Sebi is planning to introduce Mutual Fund Lite regulations for passive funds, wherein investment decisions are not discretionary, but tied

to changes in the underlying benchmark index.

"These new regulations are expected to significantly reduce the compliance requirements of such funds and to foster innovation in the passive fund ecosystem," the regulator said.

A passive fund is an investment vehicle that tracks a market index or a specific market segment. These funds include passive index funds, Exchange Traded Funds (ETFs), and Funds of Funds investing in ETFs.

The regular mutual fund schemes, which raise money from the public, have to comply with several regulations. In regular mutual funds, investment decisions are at the discretion of the fund manager and since lakhs of small investors trust mutual funds, these have stringent requirements, including high Asset Management Companies (AMC) net worth, an experienced investment team, among others, Sebi said.

However, if a mutual fund desires to offer only passive investment products such as ETFs and index funds -- where investment decisions are not discretionary, but are tied to changes in the underlying benchmark index -- then there is a case to provide them a regulatory framework with fewer compliance requirements. Accordingly, Sebi is currently engaged with the mutual fund industry to introduce 'MF Lite' for such entities.

Earlier in May, Sebi Whole-Time Member Ananta Barua said the regulator will come out with mutual fund light regulations for passive funds.

To balance the need for facilitating financial inclusion, encouraging new participants, leveraging economies of scale, encouraging adoption of technology, discouraging cross-subsidisation across schemes, closing arbitrage opportunities and curbing malpractices, if any, the current regulatory provisions applicable for fees and expenses charged by the mutual fund industry will be reviewed, Sebi said.

In May, the regulator came out with a consultation paper proposing changes to mutual funds' total expense ratio, which accounts for the fees and expenses charged by AMCs. However, the same was not welcomed by the industry and the regulator is likely working on a new proposal now.

To provide additional investment products for the mutual funds, Sebi is considering allowing mutual funds to sell credit default swaps (CDS) to take exposure in synthetic corporate bonds, i.e., a position created by selling credit default swaps and buying G-Sec/ T-bills.

A credit default swap is a financial derivative/contract that allows an investor to “swap” their credit risk with another party.

To ensure institutional accountability of the Asset Management Companies (AMCs) and their senior management personnel for misconduct by respective employees and other related entities, Sebi said it is being considered to mandate AMCs to set up institutional mechanisms for deterrence of possible market abuse and fraudulent transactions, and ensuring appropriate escalation and reporting mechanism.

To improve resilience and transparency regarding portfolio managers, the capital market regulator said it has specified cyber security and cyber

resilience framework, guidelines regarding performance benchmarking and valuation norms, prudential limits for related party investments and measures to strengthen the systems of the portfolio managers.

In furtherance of these initiatives, Sebi is exploring the standardisation of disclosures by Portfolio Managers.